The Next Big Financial Crisis That Could Cripple Cities

Cities are constantly righting the wrongs of decades past. The miscues of the urban renewal era – windswept plazas, hulking parking garages, and the elevated freeways blasted through downtowns across the country – have kept planners busy over the last 50 years. But there are other policies that have a lasting and devastating impact on the health of cities. That’s currently on sad display as municipalities try to deal with the ticking time bomb of public employee pensions.

State government pensions have dominated the headlines, beginning, as ever, with California. Less well known is the plight of local governments, struggling with the very same problem. There are 220 state pension plans but nearly 3,200 locally administered across the nation, wreaking havoc on municipal budgets already in tatters.

Like many urban renewal plans, generous pensions for a range of city employees were established with the best of intentions, in the context of another era. Awarding pensions – long since been phased out in the private sector and replaced with individual retirement accounts to which employers often contribute over the course of one’s career – was seen as a way of rewarding public service, particularly for salaries that were not competitive with the private sector.

If trends continue, over half of every dollar in municipal tax revenue would go to pensions.

Also similar to urban renewal, there were excesses over time. So there are uniform allowances that continue on through retirement, or the common practice of "spiking" or boosting pensions in the final year of employment, all gained quietly through collective bargaining.

The main problem is structural, however. What’s done is done. Just like the states, municipalities must honor the pension payouts, regardless of the performance of the portfolios, which have taken a beating since 2008 just like everyone else’s 401(k) plans.

Municipalities have an even harder time covering monthly pension obligations; most depend primarily on property tax revenue, along with dwindling state aid and limited other tax revenues. And then there is the ongoing post-2008 public finance crisis. Cities are struggling to pay for other things; many have drastically cut back services, from police patrols to keeping streetlights lit. They have laid off current employees as stimulus funding has run out. Some have declared bankruptcy.

The really bad news is in the future, however. Researchers have estimated that the aggregate unfunded liabilities of locally administered pension plans tops $574 billion. In what amounts to some scary reading in the world of public finance, Tracy Gordon and Ilana Fischer at the Brookings Institution and Heather M. Rose at the University of California, Davis, have detailed this unfolding story in a recently published paper, summarized as well by Gordon and Richard F. Dye of the University of Illinois at Chicago in the current issue of Land Lines. The conclusion is that local governments have not set aside enough funds for pension liabilities, and are borrowing heavily and shifting the burden to future taxpayers.

On average, pensions consume nearly 20 percent of municipal budgets. But if trends continue, over half of every dollar in tax revenue would go to pensions, and by some estimates in some cases would suck up 75 percent of all tax revenue. That’s not sustainable for a healthy city, much less one teetering on bankruptcy. For one thing, what would happen to schools? Revenues from the property tax – much-maligned and frequently subjected to caps – are the primary funding mechanism for public education.

There have been drastic steps to head things off. Springfield, Illinois proposed slashing teachers benefits by $800 million. Atlanta sought to loosen restrictions to allow putting pensions in alternative investments. Other cities have reduced benefits and cost-of-living increases, and put new employees on defined benefit plans. Prichard, Alabama, a town of roughly 20,000, simply stopped sending pension checks in September 2009 and declared bankruptcy one month later.

The greatest success seems to be in places that negotiate with unions in an all-in-this-together approach, coupled with ballot measures authorizing the needed retrofitting. In Rhode Island, State Treasurer Gina Raimondo, a former venture capitalist, led an effort to save that state’s cities and towns about $100 million in this fiscal year and $1 billion over the next 20 years.

Chipping away at the problem is promising. But $574 billion is a big number. Budget-crunchers in cities and towns must be looking askance at the NFL, which famously locked out referees in a labor dispute over retirement benefits. The league, which reached agreement Wednesday night following blown calls by replacement officials, was looking to save about $3 million a year in pension contributions for some referees. For local governments today, that’s a rounding error.